FYI | Jul 14 2008
By Chris Shaw
Recent commentary from the US Federal Reserve has shown a shift from being concerned only about the risks to economic growth in the US to a more balanced outlook where the outlook for inflation is of equal concern for policymakers.
The question is will the Fed move to address the inflation outlook in the short-term given the generally weak outlook for the US economy, with Commonwealth Bank economist Nicola Chadwick suggesting such a move is unlikely given what remains a fragile economic outlook.
Fed comments suggest much the same thing, as chairman Ben Bernanke recently said until there were more signs of stability in the US housing market the growth risks to the US economy would remain to the downside. With such an outlook, and in the bank’s view there is little chance of the US housing sector stabilising before early in 2009, Chadwick sees the Fed as reluctant to make a move on inflation through lifting interest rates.
A number of factors support the bank’s view there remains further downside risk for house prices, including excess inventory that will weigh on activity levels in the economy generally, and higher mortgage rates. This combination should ensure softer demand for houses in Chadwick’s view, particularly as credit conditions are tighter and the labour market is showing signs of being under pressure.
Even US demographics are not supportive for housing in general as population growth is now declining and should continue to do so in coming years, while as Chadwick points out in terms of comparing house prices to rents it suggests house prices remain overvalued even after the market has come down by around 20% from its peak of a few years ago.
This overvaluation of house prices is contributing to an increase in delinquency rates as more borrowers simply walk away from their properties as the equity in the homes falls, with Chadwick noting the falling wealth effect of declining house prices is continuing to impact on consumption rates in the broader economy.
While there is clearly a lot of bad news in place at present Chadwick does highlight some encouraging signs for the US economy generally as fiscal initiatives should provide some growth stimulus, the weakness in the US dollar has provided support for exports and interest rates appear to have peaked at a lower level this cycle than was previously the case, which suggests a shorter economic slowdown.
Given the outlook for the US economy Chadwick takes the view the US Federal Reserve will decide to hold off on rate hikes until the housing market achieves a firmer footing, with history supporting such a view given the only previous time the Fed has lifted rates in the face of falling house prices since the mid-1970s was during a period of double-digit inflation in the 1980s.
The fact inflation at present is a long way from this level suggests the Fed will wait before feeling the need to act to bring inflation under control by moving to normalise the level of interest rates.
